Recap: U.K. Budget

U.K. Treasury chief George Osborne said economic growth would be much slower than expected and his government would have to borrow almost $90.6 billion more than planned, which is likely to fuel criticism of his austerity drive.

It won’t be the first time that a U.K. finance minister has found himself at odds with his euro zone peers, but George Osborne is probably quite content with the timing of Cyprus’s bailout imbroglio. He can’t expect much political cover for what is sure to be a tough Budget speech, but at least Cyprus might offer him some market cover, as investors choose to fret about the euro instead.

So far, indeed, the budget seems not to have figured much in sterling money-market trade this morning. The pound rose from a one week low against the dollar as the minutes of the Bank of England’s last monetary conclave showed more opposition to further stimulus than markets expected, and more explicit concern about a weak pound. Gilts are off, but that, too, seems to be down to the BoE as well.

Markets well know the U.K. is in a tight spot. Mr. Osborne isn’t going to change that view.

The U.K. economy has suffered four quarters of growth contraction in the last five, and, given the Chancellor’s lack of stimulatory fiscal scope, he’s not going to be able to do a lot to help in the quarters ahead.

An official growth-forecast downgrade for this year to a miserable 1%, from 1.2% is expected, which will bring U.K. official forecasts into line with those of the IMF, incidentally.

Most policymakers try to talk their currency down. The Bank of England seems to be doing the opposite, shortly before the U.K. Chancellor begins a Budget that is seen in some quarters as likely to deliver a dent to the pound.

It’s hard to see that as anything other than ‘we don’t like it,’ in some circumstances at least. And why should they? Currency weakness helps economies only when they have lots to export. As Kit Juckes, chief currencies analyst at Societe Generale says, the U.K. exports ‘bombs and fold-up bikes.’ Not the most currency-sensitive exports in the world. Sterling weakness can be said to do the U.K. more harm than good. (You can read more on that here.)

Last week, BOE Governor Mervyn King said the BOE wasn’t actively seeking to weaken the pound. Today’s minutes back that up.

This could get very interesting in just a few minutes, as the U.K. Budget starts at 1230 GMT.

“Any growth initiatives would be helpful for sterling,” said Daragh Maher, a currencies analyst at HSBC in London. The opposite also holds true.

Further detail in the Budget on a potential shift in the BOE’s remit, could also fuel expectations of more easing, denting the pound.

It’s worth repeating for our readers outside the U.K. that the political debate here is almost all about the need for extra public spending — called for by the opposition Labour Party and strongly resisted by the governing coalition.

The coalition isn’t opposed to public spending on capital projects but is opposed to extra current spending.

By contrast, outside a few conservative think tanks, there’s very little discussion about the advantages of reduced taxation in boosting economic growth.

Surprisingly too, there’s little talk of wealth redistribution, even though the concentration of wealth among the rich, as in the U.S., is another factor keeping economic growth subdued.

Not in the present, for sure, but take a look at the IMF’s latest growth forecasts.

They predicted that the U.K. will grow by 1% this year, and 1.9% next.

Not thrilling, to be sure, but ahead of predictions for France and Germany, and well ahead of Italy and Spain.

In a game of relative strength, Osborne must be praying they are right, and that his hand will have strengthened by the time U.K. elections roll round in 2015. None of that will help him much today though…

The Chancellor says the Budget is fiscally neutral – in other words, it won’t make the gap between income and spending any wider or any narrower. Some Keynesian economists would argue that the deficit should be increased to boost the economy.

However, other economists reckon that the way to reduce your debts is not to borrow more but to cut back your spending.

As for changing the Bank of England’s remit, the new rules are more like those of the U.S. Federal Reserve. However, the Fed’s unemployment target is conditional on consumer price inflation remaining below 2.5%. UK CPI inflation is now 2.8% and rising.

George Osborne wants to alter the Bank of England’s remit, but subtly, to allow the issuance of forward guidance on interest rates and the use of “intermediate thresholds,” for rate action, such as the Fed’s pledge to keep rates low until the labor market picks up to a certain speed.

Not entirely unexpected but, still, if three years of record low interest rates and the largest program of quantitative easing relative to GDP in the world have not brought sustainable growth, is this really going to do the trick?

Here’s hoping, but suspicions of a ‘lost decade’ in the mould of Japan’s aren’t going to be alleviated by this measure.

As expected, the Bank of England’s new remit is still based around the 2% inflation target, says analyst Annalisa Piazza at Newedge Strategy.

However, Mr. Osborne has presented a somewhat more flexible approach, she adds. Unconventional tools are now recognized by the new remit, implicitly supporting the use of quantitative easing in order to stimulate the U.K. economy.

Forward guidance on future policy, as given by the U.S. Federal Reserve, might also be introduced. The changes will be officially introduced with the August Inflation Report, the first under the new governor Mark Carney, says Ms. Piazza.

Mr. Osborne seems to be putting the State into the frame vacated by the banks, and all the 100%-plus mortgages which melted away as the financial crisis struck. He’s offering to help those who want to buy a home, who can afford a mortgage but not a deposit, and putting GBP3.5 billion into home buying programs.

This is a bold move, and he obviously believes it will keep the crucial housing market underpinned despite the economic uncertainty elsewhere.

In the U.K., owning your own home is an aspiration for almost everyone so spending £3.5 billion to support home buyers, offering new mortgage guarantees to lenders and guaranteeing to support £130 billion of mortgages from 2014 will be popular measures.

However, some would argue that investing in homes rather than industry is a poor allocation of resources.

After all, if all the money invested in ever smaller musical devices and smart ‘phones had been ploughed into science and engineering, we’d probably have established a colony on the moon by now.

George Osborne has done the only thing he could have done, politically at least: doubled down on austerity while doing all he can within an extremely restrictive fiscal remit to encourage private-sector growth and employment.

The markets will obviously want more detail on plans to alter the Bank of England’s monetary policy remit, and on the new and extensive support proposed for the housing market. But, for the moment, they seem to be at least sanguine. Sterling has just traded at $1.5154, to mark a fresh high for the day.

So the U.K. coalition government has decided not to listen to the siren calls of the opposition Labour Party and borrow more to stimulate economic growth. That will anger those Keynesian economists who have called for increased public spending but please those who have argued for lower taxes to encourage entrepreneurs.

“As expected, the key message from the U.K. Budget is that the government is sticking doggedly to its austerity plans, regardless of the weakness in the economy,” says Vicky Redwood, chief U.K. economist at Capital Economics. “The overall package was fiscally neutral and there were virtually no surprises in the announced measures, other than an ‘employment allowance’ to reduce national insurance contributions for small firms,” she adds.

However, the Chancellor has altered the Bank of England’s remit in the hope that easier monetary policy will stimulate growth in the absence of extra public expenditure. The problem is that injecting more money into the economy raises the risk of even higher prices in a country already suffering from stagnant growth and high inflation – the dreaded ‘stagflation’.

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